Guide to Financial Ratios Analysis - Free Small Business ...

Guide to Financial Ratios Analysis

A Step by Step Guide to Balance Sheet and Profit and Loss Statement Analysis

By BizMove Management Training Institute

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Table of Contents

1. Introduction

2. Current Ratios

3. Quick Ratios

4. Working Capital

5. Leverage Ratio

6. Gross Margin Ratio

7. Net Profit Margin Ratio

8. Inventory Turnover Ratio

9. Accounts Receivable Turnover Ratio

10. Return on Assets Ratio

11. Return on Investment (ROI) Ratio.

12. Understanding Financial Statements:

1. Introduction

If you are not fully familiar with the structure of financial statements please read first the

bonus guide: Understanding Financial Statements.

What is ratio analysis? The Balance Sheet and the Statement of Income are essential,

but they are only the starting point for successful financial management. Apply Ratio

Analysis to Financial Statements to analyze the success, failure, and progress of your

business.

Ratio Analysis enables the business owner/manager to spot trends in a business and to

compare its performance and condition with the average performance of similar

businesses in the same industry. To do this compare your ratios with the average of

businesses similar to yours and compare your own ratios for several successive years,

watching especially for any unfavorable trends that may be starting. Ratio analysis may

provide the all-important early warning indications that allow you to solve your business

problems before your business is destroyed by them.

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Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a business's ability to

pay its bills as they come due) and leverage (the extent to which the business is

dependent on creditors' funding). They include the following ratios:

Liquidity Ratios

These ratios indicate the ease of turning assets into cash. They include the Current

Ratio, Quick Ratio, and Working Capital.

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2. Current Ratios

The Current Ratio is one of the best known measures of financial strength. It is figured

as shown below:

Current Ratio =

Total Current Assets

____________________

Total Current Liabilities

The main question this ratio addresses is: "Does your business have enough current

assets to meet the payment schedule of its current debts with a margin of safety for

possible losses in current assets, such as inventory shrinkage or collectable accounts?"

A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is

satisfactory depends on the nature of the business and the characteristics of its current

assets and liabilities. The minimum acceptable current ratio is obviously 1:1, but that

relationship is usually playing it too close for comfort.

If you decide your business's current ratio is too low, you may be able to raise it by:

Paying some debts.

Increasing your current assets from loans or other borrowings with a maturity of more

than one year.

Converting non-current assets into current assets.

Increasing your current assets from new equity contributions.

Putting profits back into the business.

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3. Quick Ratios

The Quick Ratio is sometimes called the "acid-test" ratio and is one of the best

measures of liquidity. It is figured as shown below:

Quick Ratio =

Cash + Government Securities + Receivables

______________________________________

Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By excluding

inventories, it concentrates on the really liquid assets, with value that is fairly certain. It

helps answer the question: "If all sales revenues should disappear, could my business

meet its current obligations with the readily convertible `quick' funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your "quick assets"

are in accounts receivable, and the pattern of accounts receivable collection lags behind

the schedule for paying current liabilities.

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4. Working Capital

Working Capital is more a measure of cash flow than a ratio. The result of this

calculation must be a positive number. It is calculated as shown below:

Working Capital = Total Current Assets - Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company's ability to

weather financial crises. Loans are often tied to minimum working capital requirements.

A general observation about these three Liquidity Ratios is that the higher they are the

better, especially if you are relying to any significant extent on creditor money to finance

assets.

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5. Leverage Ratio

This Debt/Worth or Leverage Ratio indicates the extent to which the business is reliant

on debt financing (creditor money versus owner's equity):

Debt/Worth Ratio =

Total Liabilities

_______________

Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in

your business, making it correspondingly harder to obtain credit.

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Income Statement Ratio Analysis

The following important State of Income Ratios measure profitability:

6. Gross Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the cost of goods sold

from net sales. It measures the percentage of sales dollars remaining (after obtaining or

manufacturing the goods sold) available to pay the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will reveal the relative

strengths or weaknesses in your business. The Gross Margin Ratio is calculated as

follows:

Gross Margin Ratio =

Gross Profit

_______________

Net Sales

(Gross Profit = Net Sales - Cost of Goods Sold)

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7. Net Profit Margin Ratio

This ratio is the percentage of sales dollars left after subtracting the Cost of Goods sold

and all expenses, except income taxes. It provides a good opportunity to compare your

company's "return on sales" with the performance of other companies in your industry. It

is calculated before income tax because tax rates and tax liabilities vary from company

to company for a wide variety of reasons, making comparisons after taxes much more

difficult. The Net Profit Margin Ratio is calculated as follows:

Net Profit Margin Ratio =

Net Profit Before Tax

_____________________

Net Sales

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Management Ratios

Other important ratios, often referred to as Management Ratios, are also derived from

Balance Sheet and Statement of Income information.

8. Inventory Turnover Ratio

This ratio reveals how well inventory is being managed. It is important because the

more times inventory can be turned in a given operating cycle, the greater the profit.

The Inventory Turnover Ratio is calculated as follows:

Inventory Turnover Ratio =

Net Sales

___________________________

Average Inventory at Cost

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9. Accounts Receivable Turnover Ratio

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